Hey big lenders

Non-bank home lenders are being muscled out as the credit crunch leaves them unable to compete with the big banks - and that means higher interest rates all round, write Stuart Washington and Clancy Yeates.

By Stuart Washington and Clancy Yeates

31 May 2008 — 12:00am

Looking for someone to write you a cheap mortgage? Don't go to Virgin Money.

Why not?

Because the business, previously funded by Macquarie Group, can't get money at the right price and its doors are closed to new business. Or, as Virgin Money spins it on its website: "The cost of money is currently so high that we're unable to bring you the great value home loan we're synonymous with."

So tough luck.

And tough luck if you're a franchisee with mortgage provider Wizard as well. One of the biggest financial powerhouses in the world, GE Money, can't figure out how to make the business work properly and is looking to sell it.

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Or, as GE Money's Australian chief executive, Mike Cutter, spins it: "A different ownership structure will allow GE Money to make the best use of capital and focus on higher returning segments that better leverage our core strengths."

And if you're wondering how Mark Bouris is thinking he will turn a buck from the Wizard business he ] sold to GE for $500 million in 2004, you are not alone.

There are plenty in the industry scratching their heads about Bouris's open flirtation with buying back into a non-bank lending industry facing serious challenges.

In fact, there's plenty of tough luck to be had all round for anyone relying on the frozen credit markets. And that means tough luck for anyone who has a home loan.

There is one simple message for a home loan borrower: Your mortgage rate is going to go up as a result of the credit crisis. Again.

Yes, it's going to go up even more than it has already gone up. Yes, it's likely to go up whether you are with a bank or a non-bank lender. And it is going to go up independently of any moves by the Reserve Bank on the official cash rate.

Don't take our word for it. This is what the head of Australia's largest home loan lender, Commonwealth Bank's chief executive, Ralph Norris, said this month: "Over time, interest rates being charged will increase unless we see significant drops in rates both internationally and locally."

The dire fate facing non-bank lenders - and home loan borrowers in general - started with the unprecedented ructions emanating from the awful performance of US subprime loans.

Global confidence in the debt markets was knocked for a six. The costs for banks to borrow money leapt from about 0.3 percentage points above a benchmark rate to 1.3 percentage points above a benchmark rate for three-year loans.

As Ben McCarthy, the managing director of structured finance for Fitch Ratings said this week: "If you had asked people what their disaster scenario was in May last year, they would not have come up with this."

In Australia, the resulting credit freeze has included higher-priced debt and the absence of investor interest in refinancing existing debts - leading to the collapse of home lender RAMS. Crucially, it also led to the complete closure, until recently, of the market for packaged mortgages.

In the six months to June 30 last year this method of financing mortgages raised $45 billion. In the six months to December 31, the financing slumped to $6 billion as investor interest rapidly dwindled. Up until May 15, there were no sales of packaged mortgages.

Before the credit crisis, packaged mortgages were the principal way many lenders financed their loans and competed with the big banks. The roll call of lenders that suddenly found their cash tap turned off include non-conforming lenders such as Liberty, Pepper and Bluestone, regional banks such as Adelaide Bank, and prime lenders such as Challenger.

GE Money's potential sale of Wizard demonstrates the vulnerability of lenders relying on any source of funding other than deposits Wizard funds loans through its balance sheet of its much larger parent, whose AAA credit rating surpasses the big four domestic banks.

GE Money's Cutter says: "We fund the book 100 per cent through wholesale funding, we don't use securitisation." But even this is not enough. "Since the credit crisis, the price of wholesale funds has increased higher than the cash rate in Australia."

As the price of credit rose, GE Money's return on investment struggled, and the returns were not strong enough to satisfy the global giant during the current lean period. The competition for the big banks provided by the non-bank lenders was a big deal for the Australian consumer. Non-bank lenders lay claim to cutting the overall mortgage lending rate by 2 percentage points after launching aggressive competition with the banks since the mid 1990s.

That competition has dissipated and banks are eagerly soaking up market share, returning to their strongest position in 13 years.

"Now more than ever they have picked up a lot of bargaining power when it comes to the consumer," Bluestone's chief executive, Peter McGuinness, says. "And the danger is they will seize that opportunity to start widening margins."

Lisa Montgomery, the head of consumer banking for non-bank mortgage provider Resi says: "From a competition perspective they would be more than happy if the non-bank sector disappeared."

Did we mention interest rates were going to go up?

In recent weeks there have been tentative signs of a thawing in the credit market, with two major securitisations sold to the market. But only at a price.

Kevin Lee, the division director of debt finance for Macquarie Group, finds great relief in the fact investors have been willing to buy packaged-up home loans.

"Onshore and offshore investor interest is improving," Lee says. "I don't think any of this is permanent. It's very tough right now and it is obvious we are seeing some players exiting the market or winding back. In the medium term business models can adapt and say, 'If that's the new cost of funds, this is what I need to do to make this profitable."'

In this new world, there is one overriding reality: higher interest costs for borrowers.

On May 16 multinational investment bank Citi sold a $500 million package of Australian mortgages to investors. But for this drought-breaking transaction, investors will receive 1.45 percentage points above a benchmark rate compared to 0.16 percentage points for a similar transaction before the credit crisis.

And in the other notable mortgage transaction, financier GMAC sold its AAA rated product at a staggering 3 percentage points above a benchmark rate.

In short, the maths of selling packaged mortgages is not stacking up. And they particularly don't stack up in the low-documentation or non-conforming end of the market where investors want a great deal of reward for the risk they are being asked to take on.

The same problems affect GE Money, and, in fact, any lender. If GE Money were raising funds over a five year term, it would have paid a premium of about 0.2 percentage points above the benchmark rate a year ago, and 1.16 percentage points more now, a credit analyst said. This is a stark contrast to the previous era of cheap credit when pricing shifts between different lenders and different types of loans were minimal.

"What we're hearing is that there's a much bigger differentiation between types of lenders and types of mortgages," says McCarthy.

The resulting picture, even after the recent successful sales of packaged mortgages, is a two-tier market where banks are dominant and non-bank lenders are hard pressed to find suitable funding.

And even if non-bank lenders are able to find funding, they may be forced into areas banks no longer want to touch because of banks' reluctance to take on the perceived risk.

The harsh realities have forced Bluestone to dramatically scale back its lending business as it reconsiders its business model. Along the way it has reduced its staff numbers from about 160 last year to about 80 today.

McGuinness says the previous model of selling packaged mortgages to investors is simply not viable at levels of more than 2 percentage points above a benchmark rate.

There's another challenge for non-bank lenders: in many cases they have depended on "warehouses" for funding, which allowed them to provide a whole series of loans before they were packaged and sold to investors.

Most of these warehouses were provided by large banks. They don't want to do it any more - particularly for non-conforming loans. "There's no confidence from any funder to actually provide funding for these products," McGuinness says.

So the banks hold all the cards. Or, as he puts it: "In the short term the banks could make life extremely difficult."

McGuinness repeats a sentiment held by many non-bank lenders: Bluestone's loan business is in "hibernation" until conditions improve.

In the meantime Bluestone is changing its business from originating loans to that of a mortgage manager, taking fees from the $3 billion in mortgages it has previously written.

Fitch's McCarthy makes the point that non-bank lenders have been reasonably quick to "cut off the front end" - the sales forces and broker networks that sold the mortgages - to focus on profiting from the mortgage books they have previously written.

And McCarthy makes the valid point that while non-bank lenders' business models are under threat, the credit quality of Australian packaged mortgages has performed very strongly in contrast to the dreadful loans that were written and sold in the US. A US website, titled the Mortgage Lender Implode-O-Meter, says that 262 major US lending operations have "imploded" since late 2006.

In Australia, RAMS collapsed, but this was not because of the credit quality of the loans it had written, but being caught out by its funding structure. "Effectively we're getting beaten up for what somebody else has done," McCarthy says.

But there is likely to be more tough luck ahead. The banks are already flexing their bargaining power when it comes to the network of brokers that rely on both volume and commissions to make a living from the sale of mortgages.

Volume is down. And banks are using their new-found market dominance to push commissions down.

"Brokers are definitely feeling the pinch," says Montgomery. "We will see some consolidation in the market, particularly in the broker sector."

In the context of the Wizard sale - GE Money says it expects Wizard would sell for more than the $500 million it paid for the business - franchisees must be wondering exactly what they have got themselves into.

One possibility in the sale of Wizard is that the real value of the franchisee network is as a broker network for someone who wants to write and distribute loans - like a bank.

There are bold proposals for ways to improve the faltering packaged mortgage market, which is also known as securitisation.

The Australian Securitisation Forum is promoting a Canadian model that would offer lower-cost funding and cut 1.5 percentage points off mortgage rates. Others point to the government-supported lending models of US lenders Freddie Mac and Fannie Mae.

These are attractive propositions, no doubt.

But the proposals require both industry support and Federal Government guarantees that would underpin investor confidence.

"I'm not a huge believer in the 'Aussie Mac' proposal," says McGuinness.

Macquarie's Lee says: "I think there's a long way to go on those. There's a lot of debate around the pros and cons of those sorts of models."